How Small Business Taxes Work


You may know coffee beans, but do you know business structures, or how the different business structures are taxed?
You may know coffee beans, but do you know business structures, or how the different business structures are taxed?
© Sollina Images/Blend Images/Corbis

I used to be a small business. I was owner and worker in one. Now I own a small business, and that business pays me a salary. There is Owner me, and there is Employee me. This distinction saves me three grand a year.

Confused? So was I. You'll get it soon.

Different types of business often receive different treatment in the U.S. tax code. Business classifications, legal status and varying tax structures all play a part in how much a given business has to pay. And the Internal Revenue Service's distinction between the "small business" and the "business" adds some extra room for confusion, because there is no single, all-encompassing way to differentiate between the two.

The U.S. Small Business Administration looks at several factors when designating an operation a "small business." Some of the big ones are: a) it is independently owned and operated; b) it is not an industry leader; and c) it has less than either a certain number of employees or a certain amount in annual receipts averaged over three years [source: Beesley].

The "less than" factor varies widely by industry. For instance, in manufacturing and mining, business size is usually determined by number of employees, and "small" means fewer than 500. In renewable electric power generation, the maximum number of employees is 250. For new-car dealers, it's 200 [source: SBA].

Used-car dealers, on the other hand, are judged by average annual receipts, and "small" dealers average less than $25 million a year [source: SBA]. In agriculture and construction, the maximums are typically $750,000 and $36.5 million, respectively [source: SBA].

That's in 2014, at least. It sometimes changes. But it's worth staying current with the SBA designations, because tax-wise, it can make a real difference.

Basic Business Taxes

Federal taxes on businesses, small or large, fall into four basic categories:

Income tax is levied on a business's taxable income, or net profit. To get to net profit, you take gross (total) profit, typically the money that comes in from sales of goods or services, and subtract business expenses (such as office supplies, rent or the purchase of a new company vehicle) [source: Nikolakopulos].

Employment taxes are taxes levied on wages. They include income tax (on the income of the person, not the company), Social Security and Medicare contributions, and federal unemployment tax. For Social Security and Medicare taxes, employers and employees split the cost, each paying half the amount due. In most cases, employment taxes are automatically withheld from paychecks as they're issued [source: IRS].

Self-employment tax is levied on business owners who do not pay themselves wages or do not withhold employment taxes from those wages as they go. Self-employment taxes cover Social Security and Medicare contributions; if owners want to set aside money in case of unemployment, they need to do it themselves [source: Entrepreneur]. Self-employment taxes cost twice as much as employment taxes since no one is splitting the cost [source: Dratch].

Excise tax applies to businesses operating in particular industries (with no apparent rhyme or reason) and includes special taxes on retail sales of goods like alcohol, tobacco, fuel and flu vaccines, as well as services like gambling, telecommunications and indoor tanning [source: IRS]. It also applies to manufacturer sales of goods like coal and fishing poles [source: IRS].

Excise tax is typically built into the price of a product or service. But for the rest of the categories, how much small businesses end up paying can vary quite a bit depending on how they're structured.

Common Business Structures: Sole Proprietorships and Partnerships

The most common types of businesses are sole proprietorships, partnerships, LLCs, corporations (or "C corporations") and S corporations [source: SBA]. These are legal designations that, for tax purposes, vary primarily in three ways: how income is taxed, how Medicare and Social Security taxes are levied and who is liable for any debts the business incurs.

The simplest structures are sole proprietorships and partnerships, and many small businesses start out in these categories because they're so easy to set up and run. They don't need to formally organize with any state agency. If you work for yourself/selves and haven't selected a business structure, you're basically considered a sole proprietorship or partnership as far as taxation goes [source: FindLaw].

Liability

Sole proprietorships and partnerships are not legal entities, which means they don't exist apart from their owners. Businesses finances and personal finances are one and the same, so owners are personally responsible for any debts incurred (or legal actions brought against) their companies [source: SBA].

Income Tax

Sole proprietorships and partnerships do not pay income tax at the business level. Business profits "pass through" the company to its owner(s). Income is taxed at the individual level and is reported at the end of the tax year on the owners' individual returns [source: IRS]. (Partnerships also have to file an "information return" at the end of the year reporting their profits and losses [source: IRS]).

Employment/Self-employment Tax

Owners of sole proprietorships and partnerships pay self-employment taxes. The entire amount of the business's taxable income is subject to self-employment tax [source: IRS].

The big upside to sole proprietorships and partnerships is simplicity. There's not much involved in forming the business, and dealing with business taxes is almost as straightforward (relatively speaking) as filing personal taxes.

On the downside, owners are personally responsible for all business liabilities. They're also taking a big hit on self-employment taxes, paying the entirety of the tax on the entirety of their profits.

To address these one or both of these downsides, business owners need to complicate things – but perhaps only slightly.

Common Basic Structures: LLCs and Corporations

The limited liability company, or LLC, is a more complicated structure to establish than a sole proprietorship or partnership, but not by much. Owners, called "members," typically just have to file one form to organize as an LLC, the "articles of organization" [source: Dahl].

Liability

An LLC is a legal entity. Its finances are separate from its owner's finances, and owners are not personally liable for debts incurred by or legal judgments made against their businesses. This is the main draw of the LLC: Owners of small businesses operating in fields with potentially substantial liability concerns, like construction or child care, are generally protected financially if something goes wrong [source: FindLaw].

Income Tax

While an LLC is a separate legal entity, it is not a separate tax entity. Income passes through an LLC just like it does for a sole proprietorship or partnership, taxed at the individual level and reported on owners' personal tax returns [source: SBA].

Employment/Self-employment Tax

LLC owners pay self-employment tax [source: SBA].

So LLCs solve the liability problem of sole proprietorships and partnerships, but they still face the hitch of the self-employment tax. To address that challenge, incorporation is required.

Corporations

Corporations can have any number of owners, or "shareholders." The structure comes with a more complicated setup process and more paperwork in general, but it can be beneficial in terms of Medicare and Social Security taxes. (Income tax, not so much.)

Liability

Corporations are legal entities, so their owners typically are not personally liable for business debts [source: IRS].

Income Tax

Corporations are separate tax entities, so they pay income tax on their profit. Owners also pay income tax on that profit when it's distributed to shareholders. This effectively means the business's profits are taxed twice: once as business income and then again as personal income [source: SBA].

Employment/Self-employment Tax

Owners of a corporation can also be employees of the company, earning wages like any other employee. They can withhold employment taxes from their wages as they go, or they can pay self-employment taxes – but only on the profits they receive as wages. The rest of the profits are considered dividends and bonuses, which are not subject to employment or self-employment taxes [source: IRS].

The big hitch with the corporation is the double income tax. Enter the S corporation, available only to smaller businesses.

Special Tax Treatment

An S corporation, or S corp, is a cross between a corporation and a sole proprietorship/partnership. It basically takes the best of both structures and combines them to offer potentially significant tax savings. Only corporations with fewer than 100 shareholders are eligible to be taxed as S corps (though some businesses, notably those in the field of finance, can never be S corps, regardless of size).

Liability

Like a C corporation, an S corp is legal entity. Owners are not personally liable for business debts.

Income Tax

Like a sole proprietorship, partnership or LLC, an S corp is not a separate tax entity, so it does not pay income tax. Profits "pass through" the company to the shareholders, so they are only taxed once. Taxable business income is reported on owners' individual tax returns.

Employment/Self-employment Tax

Owners of S corporations are also employees. They pay themselves wages, and they only pay employment or self-employment taxes on those wages, not on the company's entire profits [source: SBA].

Between single income taxation and wage-based employment/self-employment taxation, the S corp designation can result in real tax savings. Small businesses, depending on how small they actually are, might be eligible for some other tax perks, too, including:

  • A tax credit for company-paid health insurance premiums (for businesses with fewer than 25 full-time employees, averaging less than $50,000 in annual wages) [source: IRS]
  • Using the cash instead of accrual method of accounting for tracking inventory, so sales count as income when the customer pays, not when the order is placed (for businesses with less than $10 million in annual receipts) [sources: Sherman, IRS]
  • A lower penalty cap for late filing of information returns (forms, not payments): $500,000 compared with $1.5 million for large businesses (for businesses with up to $5 million in annual receipts) [source: IRS]
  • A three-year tax credit for initiating a 401(k) or other retirement plan (for businesses with 100 or fewer employees earning more than $5,000 in the year the plan is first offered) [source: Appleby]

And of course, like any other company a small business is entitled to take deductions that reduce its taxable-income amount. Some deductible expenses are obvious – office supplies, for one. Or tickets to trade shows. But others take a bit more tax savvy.

Small-business Deductions

Let's say you buy a new computer for your home office. Can you deduct the entire price when figuring your taxable income for the year?

If you're a small business, you can. While large businesses typically have to deduct the cost of new equipment over time, in the form of depreciation, a small business has the option of deducting the whole cost immediately using "first-year expensing" [source: Weltman].

In general, small businesses can "expense" everything large businesses can – office supplies, software, business travel, working lunches, company vehicles, rented office space, mileage driven to a job site ... All or some of these costs can be deducted when calculating taxable income. Small businesses might find some other deductions, too, like individual-health-insurance premiums, or a portion of their self-employment taxes [source: Dratch].

The deduction that really trips up many small-business owners is the home-office expense. It can be tricky, because you can only deduct what's solely for business use [source: Dratch]. For instance, if you live in a 1,000-square-foot (93-square-meter) home, and the room that is your office is approximately 100 square feet (9.3 square meters), you can deduct 10 percent of your mortgage payment and utility bills as a business expense. If, however, that room doubles as a den, you'll need to reduce that percentage to account for the space used for den-type activities [source: Dratch]. If you use your cell phone to make both business and personal calls, you'll need to calculate what percentage of your calls are business-related if you want to take a business-phone deduction. Same goes for your Internet connection.

And that new computer you bought for your home office? You can actually only expense the entire cost if you use it entirely for business.

Ultimately, small business owners should be cautious -- but not shy. There's no reason to give the IRS more than it's entitled to, and you don't need an accounting department to take advantage of business tax benefits. Rather than skip a deduction or credit because you're not sure, call an accountant. You'll likely end up saving more in taxes than you pay for the advice. Back when I was a sole proprietorship, I paid $80 to find out I'd be saving three grand a year if I were an S corp.

And now, I can pay someone to do my business taxes for me.

Author's Note: How Small Business Taxes Work

Now I know why God invented CPAs. Researching and writing this article was a study in minutiae, maybes and a mind-boggling variety of definitions. But this article is a review of the basics, so I ultimately went with the simplest and most widely applicable explanations of terms, requirements and distinctions between business structures. But readers beware: Every business is different, and even small differences can affect filing requirements, eligibility for credits and legitimacy of deductions. So proceed with care, and when in doubt, talk to a pro. (Or better yet, pay one to do your taxes. I do. It's wonderful.)

Related Articles

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